After China fraud boom, Nasdaq steps up scrutiny of shady listings

Nasdaq, Inc. has been checking up on the companies it lists much more closely since a 2009 boom of China-based companies using its exchange abruptly crashed in 2011, creating a massive fraud pile-up.

The Chinese reverse merger fraud crisis seemed to come out of nowhere. More than 50 U.S. listed Chinese companies were either delisted or halted from trading in 2011 and 2012 based on claims of fraud and other violations of U.S. securities laws. A number of others were the target of short sellers and changed auditors more than once in some cases.

“Billions of dollars of market capitalization of such companies have been lost in U.S. securities markets and it is fair to say that all of these smaller China-based companies listed on U.S. securities exchanges have suffered serious losses of both market value and investor confidence as a result of the problems of other companies,” said Lew Ferguson, board member of the Public Company Accounting Oversight Board, the audit industry regulator, in a speech in 2012.

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Shareholders filed 31 class action lawsuits against Chinese reverse merger companies that year, most alleging misrepresentations in financial documents, violations of federal securities laws and non- compliance with Generally Accepted Accounting Principles, or GAAP. There were no such lawsuits before 2010 but from 2010 to 2012 they accounted for nearly 10% of all securities class actions.

Not bad for a new fraud scheme.

Private Chinese companies pursued reverse mergers to gain access to U.S. capital markets more quickly and cheaply than via an initial public offering, or IPO. These companies also avoided the kind of SEC scrutiny of their share registration that would be part of an IPO, since the private company was merging with a shell that had already gone through that process, typically for another purpose a long time before.

“As a global exchange we need to be focused on determining if any of the key players are from places subject to U.S. sanctions and are legally obligated to take that into account, along with anti-money-laundering rules.”
Arnold Golub, deputy general counsel, vice president, Nasdaq, Inc.

In the summer of 2010, the SEC launched an initiative to determine whether certain companies with foreign operations—including those that were the product of reverse mergers—were accurately reporting their financial results, and to assess the quality of the audits being done by their auditors. By June 2011, the SEC was strongly warning investors of the risks posed by reverse mergers in general, and Chinese deals in particular, singling out six Chinese issuers.

Arnold Golub is deputy general counsel and vice president of Nasdaq, Inc., where he also leads Nasdaq’s listing compliance group. This group’s activities include monitoring company compliance with the exchange’s listing rules.

“We were diligent before the Chinese reverse merger frauds hit, but had to do more in light of the new threats,” he said.

Nasdaq, Inc.

Arnold Golub and Patricia Decker keep a close eye now on who is requesting a listing and their business interests and close associates.

Investors, said Golub, shouldn’t have to worry about the officers, directors and stock promoters taking advantage of them. Before and during the era of the Chinese reverse merger boom, Nasdaq believed it could trust the typical gatekeepers—investment banks, auditors and attorneys—to make sure all the information provided to the exchange and to the SEC by key players was accurate.

Total Company Listings

Total New Company Listings

Regulatory Delistings

2006

3,193

285

52

2007

3,135

290

48

2008

3,023

177

85

2009

2,852

131

105

2010

2,778

195

73

2011

2,680

151

66

2012

2,577

158

57

2013

2,637

239

31

2014

2,782

327

25

2015

2,859

274

38

Source: Nasdaq, Inc.

“We stepped up our efforts considerably when we realized that we could not rely on companies’ representations to us at all times, ” said Golub. Nasdaq was the first exchange to hire private investigators to do additional due diligence.

“We asked them to compare SEC filings to local tax filings,” Golub explained, “make on-the-ground inspections of assets and facilities, and do deeper individual background checks.” Nasdaq also asked for its own bank confirmations, either via the auditor or an independent third-party.

Nasdaq has added or enhanced several policies and procedures since 2011 and adopted stricter rules for listing reverse merger companies.

‘We wanted to do more and brought our ideas to the SEC,” he said.

The result was new rules approved by the SEC in November of 2011 for the three major U.S. exchanges that toughened listing standards for companies going public through a reverse merger.

Nasdaq, and NYSE
ICE, +0.00%
and NYSE Amex, now prohibit a reverse merger company from applying to list until the company has completed a one-year “seasoning period” by trading in the U.S. over-the-counter market or on another regulated U.S. or foreign exchange following the reverse merger. The company must also be current on all its required filing with the SEC, including audited financial statements. The company must also maintain a minimum share price—on Nasdaq it’s a minimum of $1 for continued listing—for a sustained period, and for at least 30 of the 60 trading days immediately before its listing application and the exchange’s decision to list.

Nasdaq has made some other big changes, too. The Chinese reverse merger episode encouraged the exchanges to talk more with each other, as well as with Finra and the SEC about what they were seeing, especially when the same names kept popping up. Golub says they realized that they had to look beyond just an identified high-risk headquarters location to consider where the officers, directors and investors were coming from.

“As a global exchange we need to be focused on determining if any of the key players are from places subject to U.S. sanctions and are legally obligated to take that into account, along with anti-money-laundering rules,” he said.

The exchange has automated the application process and added resources to its Listing Center to make it easier for firms to comply with its rules, to answer their own questions and for the supporting documentation and data to be analyzed by the compliance team.

Finally, Nasdaq started collecting more information about the consultants and advisers of the companies that requested a listing. “Once Nasdaq noticed that many of these reverse merger companies shared promoters, directors, audit firms, and other professional services firms, we started analyzing the network relationships to identify higher risk companies.”

The exchange had always looked at whether the auditors were subject to peer reviews, and after the Sarbanes-Oxley Act passed in 2002, whether those auditors were registered with the Public Company Accounting Oversight Board, the new audit regulator established after the collapse of energy giant Enron. In March of 2011, the PCAOB took an early look at the audit implications of the emerging issues of Chinese reverse mergers.

The study noted that as of March 2010, 24 firms audited 70% of the identified Chinese reverse merger companies. Shortly after the report was published, the top audit firm for Chinese reverse merger companies, Malone Bailey, resigned as auditor for NIVS Intellimedia Technology Group, China Intelligent Lighting and Electronics, and China Century Dragon Media and accused these companies of fraud. All three were delisted from NYSE Amex in 2011.

Four firms on the PCAOB list have since had their registrations revoked for violations of PCAOB audit standards and failure to cooperate with the PCAOB investigations. The SEC issued a cease-and-desist order this past February to the seventh-busiest firm, Frazer Frost, and its sole China client partner.

The case is pending. The SEC charged the firm and the partner for its faulty audit of China Valves. Frazer Frost and that one partner alone audited 12 Nasdaq listed Chinese companies including Rino International.

Francine
McKenna

Francine McKenna is a MarketWatch reporter based in Washington, covering financial regulation and legislation from a transparency perspective. She has written about accounting, audit, fraud and corporate governance for publications including Forbes, the Financial Times, Accountancy and the American Banker. McKenna had 30 years of experience at banks and professional-services firms, including at PwC and KPMG, before becoming a full-time writer.

Francine
McKenna

Francine McKenna is a MarketWatch reporter based in Washington, covering financial regulation and legislation from a transparency perspective. She has written about accounting, audit, fraud and corporate governance for publications including Forbes, the Financial Times, Accountancy and the American Banker. McKenna had 30 years of experience at banks and professional-services firms, including at PwC and KPMG, before becoming a full-time writer.

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